Important legal information about the email you will be sending. By using this service, you agree to input your real email address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an email. All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity.com: "

Small-cap stocks were among the biggest losers during the stock market’s rout late last year as investors worried about high leverage, but they have outperformed in 2019’s rebounding market, with shares of debt-laden companies leading the charge.

An expected pause in the Federal Reserve’s course of interest-rate hikes - and optimism that a recession is not imminent in the next 12 months - support a further run in small-caps, investors say. The caveat is that as economic growth and corporate earnings taper off, these companies will find it increasingly difficult to make payments on their borrowings.

The rebound comes after the Russell 2000 and the S&P 600 both hit levels in December that were more than 20 percent below their August peaks, which many investors consider confirmation of a bear market. The S&P 500 bottomed 19.8 percent below its September peak, just missing the bear designation.

Small-cap stocks’ performance typically tracks investor appetite for debt. Though the median debt-to-equity ratio for the S&P 500 is greater than that for the Russell 2000, small-caps are seen as more sensitive to debt concerns because such companies often secure financing through bank loans with adjustable rates rather than fixed-rate bonds.

Last year’s rise in interest rates means more and more highly-indebted companies may have to scramble to make payments. The number of companies struggling with debt obligations is near record highs, according to the Institute of International Finance.

Moreover, of Russell 2000 companies, 38.3 percent have no net income, whereas only 1.4 percent of S&P 500 companies have no net income.

Leading the way up

In December, credit spreads, the difference in yield between corporate securities and U.S. Treasuries, widened by the most in more than seven years for both high-yield and investment-grade corporate bonds, according to ICE BofAML index data.

But as credit spreads have narrowed, a sign investors are less risk-averse, small-cap stocks have climbed. They got a further reprieve last Wednesday when Federal Reserve policymakers signaled a pause in its tightening cycle.

“With still-low interest rates and an environment of still-solid growth, the concerns about how many (companies) will default are just pushed off to the next slowdown in the cycle, which we don’t see happening anytime soon,” said Kate Warne, investment strategist at Edward Jones in St. Louis.

Highly leveraged companies led the way down in late 2018 and have led the way higher this year.

In the fourth quarter, the Russell 2000 companies whose shares were in the highest quartile of percentage declines had a median debt-to-equity ratio of 41.1 percent. By contrast, Russell 2000 companies whose shares were in the lowest quartile of percentage declines had a median debt-to-equity ratio of 32.3 percent, according to a Reuters analysis.

However, in January, the first group gained 16.6 percent on average, while the second group gained just 4.7 percent.

“They’ve dropped so much that they’ve become an area of interest to screen,” said Scott Hood, chief executive at First Wilshire Securities Management in Pasadena, California, of highly-leveraged small caps.

Debt concerns linger

Yet concerns about leverage have not entirely abated as economists and market watchers anticipate the end of the current economic cycle in the next few years.

At last week’s news conference, Federal Reserve Chairman Jerome Powell said that the U.S. central bank was monitoring corporate debt levels.

At the recent World Economic Forum in Davos, Switzerland, International Monetary Fund First Deputy Managing Director David Lipton pointed to corporate debt as an economic risk.

“There’s going to be a big focus this year by companies in general, but also small caps, to de-lever as much as they possibly can before the economy deteriorates,” said Kristina Hooper, chief global market strategist at Invesco in New York.

Even those sanguine on the prospects for small caps, such as Eric Marshall, portfolio manager at Hodges Capital Management in Dallas, say they have focused more intensely on companies’ balance sheets when picking stocks.

Tim Ghriskey, chief investment strategist at Inverness Counsel in New York said the recent run-up in small caps is “simply a dead-cat bounce.”

“The levels of debt for not only small caps but also selective large caps remain an issue,” he said.

Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

What Fidelity Offers

Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.

These links are provided by Fidelity Brokerage Services LLC ("FBS") for educational and informational purposes only. FBS is responsible for the information contained in the links. FICS and FBS are separate but affiliated companies and FICS is not involved in the preparation or selection of these links, nor does it explicitly or implicitly endorse or approve information contained in the links.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

Links provided by Fidelity Brokerage Services

These links are provided by Fidelity Brokerage Services LLC ("FBS") for educational and informational purposes only. FBS is responsible for the information contained in the links. FICS and FBS are separate but affiliated companies and FICS is not involved in the preparation or selection of these links, nor does it explicitly or implicitly endorse or approve information contained in the links.

Published by Fidelity Interactive Content Services

Content for this page, unless otherwise indicated with a Fidelity pyramid logo, is published or selected by Fidelity Interactive Content Services LLC ("FICS"), a Fidelity company with main offices in New York, New York. All Web pages that are published by FICS will contain this legend. FICS was established to present users with objective news, information, data and guidance on personal finance topics drawn from a diverse collection of sources including affiliated and non-affiliated financial services publications. Content selected and published by FICS drawn from affiliated Fidelity companies is labeled as such. FICS selected content is not intended to provide tax, legal, insurance or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by any Fidelity entity or any third-party. Quotes are delayed unless otherwise noted. FICS is owned by FMR LLC and is an affiliate of Fidelity Brokerage Services LLC. Terms of use for Third-Party Content and Research.